Exploring New Forms of Economic Leverage

We watch in disbelief as financial markets retreat and the investment banking industry morphs into something yet to be determined. We are witnessing the dark side of financial leverage. While “de-leveraging” has become the buzzword du jour, we may miss the real lessons of the current crisis and the real opportunities for leverage.

The lure and risks of financial leverage

Financial leverage is a powerful accelerant in growing markets. Companies can extend their reach far more rapidly by borrowing other people’s money. They can also generate much higher returns for the equity investors if companies have opportunities for profitable growth. This is especially true when companies operate in an environment with relatively low interest rates and significant growth in global liquidity, as we have had over the past decade or so.

At every level of our society - individual, firm and government - financial leverage has proven very seductive. To given an idea of how seductive , the total amount of credit market debt in the U.S. in 1980 was about the same as our GDP but, by 2007, it had increased to 350% of GDP.

But, as we are learning, financial leverage has a significant downside as well. If the “real” economy turns down or the company fails to appropriately assess the risks with its growth strategy, financial leverage quickly becomes an albatross. The company is stuck with fixed interest payments that have to be covered every quarter. If the value of the assets being financed also deteriorates the company gets a double whammy when it comes time to refinance. And if liquidity dries up, the company is vulnerable to a triple whammy.

Financial leverage is challenging enough at an individual company level. It becomes even more challenging in our highly connected global economy, as our current crisis illustrates. When many companies are highly leveraged, if one company runs into financial trouble, it can generate a domino effect as each company struggles to cover its debt obligations and puts pressure on the companies that have borrowed from it. This is the scramble to “de-leverage” that we are now witnessing. Cash is king and leverage, once worshipped as a god, now becomes the devil.

One option - capability leverage

But, as we begin to see the very real downsides of financial leverage, we might want to explore other forms of leverage that are far more robust in times of economic downturn. For example, capability leverage—the ability to access and mobilize the resources of other companies to add more value to customers—is a powerful force for creating value in markets. Rather than one company trying to do everything, it can mobilize a broader network of participants to deliver highly specialized and flexibly tailored value to individual customers.

This approach frees up each company to focus its own resources on what it does best while accessing the world-class capability of other companies in the network. Rather than relying on a few select business partners, companies can now employ innovative new management techniques to create and coordinate networks of thousands of business partners that provide far more leverage than ever possible before. I explored this opportunity in an article on Leveraged Growth in Harvard Business Review.

Financial leverage is insidious because, unless carefully monitored, it can undermine incentives to pursue capability leverage. If a company has ready access to cash through various forms of debt, it is much more likely to feel that it can support a much broader range of business initiatives than if cash is tight. As a result, it is much easier to support a “not invented here” culture and attempt to do everything oneself. It is no accident that some of the most sophisticated examples of capability leverage have emerged among entrepreneurial companies in Asia that did not have access to financial capital.

Another option - learning leverage

Yet there’s an even more powerful form of leverage for companies to tap into: learning leverage. Learning leverage seeks to build relationships with other companies that help each company get better faster by working with others. Rather than treating existing resources as fixed, learning leverage recognizes the value for everyone in finding ways to continually push the performance envelope for all participants. In rapidly changing global markets, learning leverage provides a powerful approach to increase value delivered to customers. Learning leverage introduces a powerful compounding effect – not only does the value delivered increase with the number and diversity of participants, but more value is created by each participant over time.

Comparing the three forms of leverage

Here’s one way to look at the three forms of leverage. Financial leverage magnifies returns, but does not increase the value delivered to the marketplace. Capability leverage increases the value delivered by flexibly connecting resources that otherwise might not be accessible to customers or that might require great effort by customers to assemble on their own. Learning leverage adds even more value by enabling individual participants to deliver higher levels of performance to the marketplace as they learn more rapidly from each other.

Capability leverage and learning leverage amplify value in times of economic prosperity, but they are even more valuable in times of margin pressure. Rather than requiring one company to bear the brunt of this margin pressure, these forms of leverage make it easier for the company to focus on investments that can enhance differentiation while relying on others to deliver complementary value to the customer. In contrast to financial leverage, these forms of leverage alleviate and diffuse pressure during economic downturns, rather than magnifying pressure on the leveraged company.

With some notable exceptions in arenas like high tech and biotech, most Western companies are still just scratching the surface of the potential for capability leverage and learning leverage. Perhaps during this challenging economic time companies will have much greater incentive to explore these alternative forms of leverage. They may find that capability and learning leverage trump financial leverage.

- Learning Leverage: Organs and limbs; increasing the capabilities and strength by exercising and learning.

So according to his model, if we we look at the latest turmoil and its impact to the overall economy the following picture comes out:

The body gained a lot of weight and some vessels were blocked and unfortunately a heart attack occurred. Although some organs and limbs were impacted, the body is still alive...

So, what must we do?

Added to the efforts to let the blood reach to all parts of the body, treatment of the nervous system and the organs is essential! Then, mental and physical practice should be encouraged for the health of the entire body (including the circulatory system!).

Nice to see a very topical post John. I would observe somewhat wryly however, that even within organisations, the barriers to capability and insight leverage are enormous. NIH is alive and well...
cheers
hope you got my b'day greetings

The faulty assumption employed in financial leverage was that there was only going to be upside. Markets were only going to go up; real estate was only going to increase in value; credit would be limitless and easily accessible to all.

It seems to me that proper "hedging" was the missing fundamental here. Few were preparing for downside; considering what would happen if values decreased, or if people lost their jobs and couldn't pay back their loans.

Refusal to acknowledge the potential downside in my eyes is what fueled the inappropriate adoption of risk; for example, the flurry of no doc and/or NINJA loan approvals.

Interestingly enough, a fact that many have seemed to overlook is that the latest economic meltdown is a repeat of the Orange County scandal of the mid-1990s, but just on a magnificently larger scale. The common bond between them (no pun intended)? Mortgage derivatives and a market that refused to acknowledge all sides of the risk equation.

In the end up, the industry requires a re-shaping in the risk management arena: a re-evaluation of risk applications both proprietary and commercial. This is the only way we can stop repeating history.

I really appreciate the fact that you are trying to show everyone that value is not only measurable by money. We are in for quite an adventure!

First a few questions...

Capability Leverage:

How is this different from a traditional consulting model or outsource?

Furthermore, from an IT perspective, how is this different from a utility computing model or cloud computing?

Some comments on your leverage models:

I love the possibility of what you are proposing however, the feasibility for something like this to occur in a market like the U.S. may be blocked a every turn by intrusion in the regulatory environment necessary for it to succeed in a sustainable fashion. To support Capability & Learning Leverage in a way that would be effective, I feel that a next level business infrastructure would need to be in place which the U.S. (the epicenter of the recent quake) could not support in its present form...the EU, Asia, and Australia (I have an intuitive tingle about that market…) will have a better chance at making this move quickly. Emerging markets built on these premises you put forth will dominate future economies. No question.

What would this architecture look like? Well, I am a huge fan of doing what works and what works is nature, so I see a solution a la biomimicry. In this case, maybe a "breathing" of the economy with your three (and potentially more) leverage points as the lungs of the system, effortlessly expanding and contracting to match market pressures. (i.e. Things get bad, the system reacts with surprise and takes a quick breath inflating one of the leverage points, like a startle response almost.) Most importantly, that flexibility would need to be supported autonomously, NOT bureaucratically.

Any type of B2B (or B2C for that matter) contractual agreement would need to be modified in this environment. Almost like one "social/network contract" to be the master variable. AND this master variable would need to be as flexible and autonomous as the operative apparatus itself. IP and NDA's would need serious help too...

The biggest issue I see with this model is one of trust. I will not go into this one too much, because it would tread on too many toes of those who value individual success over that of the whole.

Paul Saffo wrote a great piece on Capitalism which I treat as great truth and a view into the issues we face...